The Curious Case of the CBOE Put/Call Ratio

The CBOE equity put/call ratio (EPCR) is an indicator that I have researched and analyzed for quite some time. It measures the total daily volume of puts and calls on the world's largest options exchange (equities only, not including ETFs). The formula is put volume divided by call volume. Traditionally, this indicator almost always comes in below 1.00, as the number of puts traded is less than the number of calls traded. This is largely due to the fact that the public almost always trades more calls than puts.

During the bull market of the 1990s/2000s, spikes in the EPCR above 1.00 often were signs of "panic bottoms" that preceded market rallies. However, since the market peaked around October 2007, we clearly have entered a much more bearish trend from a bigger picture point of view. The following chart shows the EPCR levels from 10/2007 to the present.

Daily EPCR Data

The main thing to glean from the above data is that the EPCR is currently not spiking above 1.00, despite the market hitting multi-year lows and the overall 2009 downward move. In fact, the latest reading as of Tuesday's close is around 76%, meaning that investors are only trading three quarters as many puts as calls. From a contrarian perspective, this indicates a general complacency among option traders. One would logically think that put trading would be at very high levels versus calls considering the recent market performance. This is not a likely setup indicating a major market bottom is near, in our analysis.

So what about the major spikes in the EPCR since the market highs around October 2007? There have been three major spikes in the daily EPCR level in this time period, where the reading was an extreme above 1.15. These came in March 2008, September 2008, and November 2008. How did the market fare after these extreme EPCR readings during the volatile environment of the recent past? Examine the chart below:

S&P 500 Index Weekly Chart with EPCR Spikes Notated

What can be ascertained from these three spikes since the bear market began in 2007? Well, the EPCR spikes (green arrows) have not been as solid a contrarian "buy" signal as they generally were during the bull market of the past 20 years, although two of the three did mark significant market bottoms (March '08 and November '08). The September '08 spike actually preceded the huge market move down through November. The bottom line is that each reading did mark a major market reversal point and significant trend change.

In sum, we are concerned by the relatively low EPCR readings we are currently seeing despite the market's doldrums. Secondly, one would be wise to keep an eye peeled in the future for another major EPCR spike and utilize it as a contrarian indicator to the current market direction.